How Microsoft Beat Out Apple and Became the World’s Most Va…

Digital Equipment. Sun Microsystems. Nokia. Technology history is littered with shooting-star companies that burn brightly for a time, then disappear into the night.

That’s what makesMicrosoft’s
(ticker: MSFT) recent revival so special. Under Satya Nadella’s leadership, the old tech giant pivoted, put its cash cows at risk, and successfully transitioned to the next big technology wave—cloud computing.

This week, the stock market validated Microsoft’s turnaround when its shares surpassedApple

(AAPL) as the world’s most valuable public company. The company last held the No. 1 spot in 2003.

So how did this legacy technology vendor become relevant again, and what can the industry learn from its resurgence?

The turnaround is directly linked to Nadella’s appointment in 2014, a transition that Barron’s chronicled in a cover story a year into his tenure. While Microsoft was still extremely profitable, investors had all but given up on the company, which seemed to have missed the rise of mobile. At the time, Microsoft’s stock had fallen nearly 40% since the end of 1999, versus the S&P 500’s 20% gain. Microsoft experienced mixed receptions to its Windows 8, Windows Phone, and Bing search-engine offerings. As Nadella took the top spot, Microsoft’s core Windows division had seen profits fall 18% in the prior fiscal year.

So Nadella took action. In July 2014, he wrote in a memo to employees: “Microsoft is the productivity and platform company for the mobile-first and cloud-first world,” departing from the company’s prior worldview centered around Windows.

“Nadella changed the overall direction of the company and saw the business opportunity in the cloud,” Bernstein analyst Mark Moerdler, an early bull on Microsoft stock, told Barron’s in a phone interview on Thursday.

The bet on cloud computing was prescient. Last week, Baird estimated that every dollar spent on cloud-computing services has replaced $3 to $4 of legacy technology expenditures. That means Microsoft’s cloud is getting dollars that used to go to enterprise giantsCisco Systems

(IBM). Corporate America continues to embrace the cloud’s efficiencies, a trend that could continue for years, Baird says.

A June JPMorgan survey of more than 150 chief information officers revealed that only 23% of corporate technology workloads are currently on the cloud. The same executives predicted that the figure will rise to 52% by 2023.

Nadella positioned Microsoft to become a major player in the burgeoning market. The company is now a clear No. 2, with 13% share of cloud-computing share behind Amazon.com’s
(AMZN) Amazon Web Services at 52%, according to Gartner’s 2017 figures. The gap is shrinking, as Microsoft’s Azure cloud sales rose at a 76% clip in its most recent quarter, compared with AWS’ 46%.

Perhaps no one can appreciate Nadella’s turnaround more than his predecessor. “Satya has done a phenomenal job driving Microsoft’s cloud efforts—particularly Office 365 and Azure,” Steve Ballmer, the former Microsoft CEO and current owner of the National Basketball Association’s Los Angeles Clippers, wrote in an email to Barron’s. “There is a lot of upside that has really started to show in the company’s financial results the last year. He has also brought some growth back to one of Microsoft’s biggest profit makers, Windows. That is so critical to Microsoft’s overall success.”

Nadella has also reinvigorated Microsoft’s productivity software, by emphasizing the subscription version of Office known as Office 365. The recurring revenue is an investors’ dream. Microsoft and other software makers are benefiting. “Nadella changed the culture of the company away from a product focus to one that delivers the best solution for what the customer needs,” Moerdler said.

Meanwhile, Microsoft Office for iPad was launched in March 2014, right after Nadella became CEO, a signal that the company intended to serve its customers on any platform. The tablet offering requires an Office 365 subscription for full editing capabilities.

In its fiscal-year 2014, subscriptions accounted for just 10% of its commercial Microsoft Office revenue. Three years later, the company revealed that subscription-based Office 365 sales surpassed the revenue from its traditional license sales.

The strategy to accelerate customer-focused subscriptions and the cloud business is paying off. In its most recent quarter, Microsoft said sales and earnings rose 19% and 36%, respectively. Since Nadella took over as CEO, the company’s stock has risen more than 200% and outperformed the S&P 500 by nearly 150 percentage points.

On Friday, Microsoft had a market value of $851 billion, enough to beat Apple’s $847 billion. Apple shares declined 18% in November on worries about the latest iPhone product cycle, while Microsoft stock rose 4%.

Investors are paying up for the new Microsoft, valuing the company at 23 times Wall Street’s estimated 2019 earnings. Hardware-centric Apple trades at just 13 times.

Moerdler said that Microsoft may deserve the higher multiple because of its business model. While Apple is trying to shift its narrative to services, the iPhone segment still accounts for two-thirds of Apple’s sales.

“Microsoft has far more recurring and consistent revenue streams versus Apple and is not tied to a hardware product cycle,” Moerdler said. “Microsoft’s growth opportunities are much more visible to investors.”

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